Economics Model Essay 16

(a)  Explain why the government subsidises education. [10]

(b)  Discuss whether a reduction in the subsidy on education is justified. [15]

Introduction

(a)  The question can be discussed with reference to the concepts of allocative inefficiency and income inequity.

Body

The government subsidises education to address the problem of allocative inefficiency. Allocative efficiency is achieved when it is impossible to change the allocation of resources in the economy in a way that will make someone better off without making anyone else worse off. This occurs when marginal social benefit (MSB) is equal to marginal social cost (MSC) where MSB is the sum of marginal private benefit (MPB) and marginal external benefit (MEB) and MSC is the sum of marginal private cost (MPC) and marginal external cost (MEC). External costs and benefits, or externalities, are costs and benefits of consumption or production experienced by society other than the producers or the consumers. The private costs of education are the costs of production incurred by firms such as the costs of materials and labour. These costs are passed on to consumers in the form of a positive price. Therefore, from consumers’ perspective, the MPC of education is the price that they pay for the unit of the good. Assuming no negative externalities in education consumption, the MSC is equal to the MPC. The private benefits of education are the satisfaction derived by consumers such as the higher skills and knowledge which will lead to higher income. The consumption of education produces positive externalities. For example, it leads to a more productive and innovative labour force which is beneficial to the wider community. It also contributes to the formulation of better government policies. These positive externalities lead to a divergence between the MSB and the MPB. As firms and consumers consider only private costs and benefits, the divergence between the MSB and the MPB of education results in under-consumption.

In the above diagram, due to external benefits, the MSB is higher than the MPB. Therefore, the equilibrium output level (QE) where MPB is equal to MPC is lower than the allocatively efficient output level (QAE) where MSB is equal to MSC. For the units of output between QE and QAE, the MSB is higher than the MSC. Therefore, the social welfare gain which is the area under the MSB curve is greater than the social welfare loss which is the area under the MSC curve resulting in a net social welfare gain. It follows that these units of output should be consumed. However, as firms and consumers do not consider external costs and benefits, they are not consumed which results in a deadweight loss equal to the unrealised net social welfare gain. The deadweight loss, which is the loss of social welfare due to market failure or government intervention, is represented by the shaded area. A subsidy on education will lead to a fall in the cost of production and hence a rise in the supply. When this happens, the price will fall which will lead to a rise in the quantity demanded. In this way, a subsidy on education induces consumers to internalise the external benefits.

In the above diagram, a subsidy on education leads to a fall in the MPC. If the MPC after subsidy is MPC’, the new equilibrium output level (QE’) will be equal to QAE. Apart from external benefits in consumption, education will also be under-consumed in the absence of government intervention due to imperfect information about the beneficial effects.

The government subsidises education to address the problem of income inequity inefficiency. In the free market, the prices of goods and services are determined by the market forces of demand and supply. If the income gap is large, high income individuals with a high willingness and ability to pay may push up the prices of some goods and services to the levels which make the goods and services unaffordable to low income individuals with a low ability to pay. This is a matter of concern particularly if the good is education. Inaccessibility to education by low income individuals will make it difficult for them to increase their skills and knowledge which is likely to cause them to be trapped in poverty. A subsidy on education will lead to a fall in the cost of production and hence a rise in the supply. When this happens, the price will fall which will lead to an increase in the affordability.

Conclusion

In conclusion, as education is a merit good, under-consumption has serious social and economic implications. Therefore, the government should intervene in the market to correct the market failure.

Introduction

(b)  The question on whether a reduction in the subsidy on education is justified can be discussed with reference to the concepts of allocative inefficiency, income inequity and rising public debt-to-GDP ratio.

Body

A reduction in the subsidy on education may be justified on the grounds of addressing the problem of allocative inefficiency. For a subsidy on education to correct the market failure, it must be equal to the marginal external benefit, assuming no other causes of the market failure. Assume that the subsidy on education is initially equal to the marginal external benefit. When national income rises over time, the demand for normal goods which include education will rise which will lead to an increase in the quantity. When the quantity of education rises, the total external benefit will rise at a decreasing rate which means that the marginal external benefit will fall. If the government keeps the subsidy on education the same, it will lead to over-subsidisation resulting in over-consumption. Therefore, the government should decrease the subsidy to avoid the problem of over-subsidisation and hence over-consumption. However, the subsidy on education may initially be lower than the marginal external benefit. This could be due to a budget constraint faced by the government. If this happens, a decrease in the marginal external benefit of education may not lead to over-consumption. Therefore, it may not be necessary for the government to reduce the subsidy.

A reduction in the subsidy on education may be justified on the grounds of addressing the problem of income inequity. When national income rises over time, the incomes of low income individuals rises. Therefore, assuming the cost of education remains the same, the government may not need to provide the same level of subsidy to ensure the affordability of education to low income individuals. However, when national income rises over time, the demand for normal goods which include education will rise which will lead to a rise in the price. In the event that the proportionate increase in the cost of education is greater than the proportionate increase in the incomes of low income individuals, the government should increase the subsidy to ensure the affordability to low income individuals. This may happen if the increase in national income is concentrated in the hands of high income individuals, with low income individuals experiencing only a small increase in their incomes.

A reduction in the subsidy on education may be justified on the grounds of addressing the problem of a rising public debt-to-GDP ratio. A persistently large budget deficit will lead to a rising public debt-to-GDP ratio. In time to come, people will lose confidence in the government’s ability to repay its debt which will cause the government to lose its ability to borrow. When this happens, the government will not be able to meet its debt obligations which will lead to a sovereign default. A sovereign default will lead to a fall in aggregate demand resulting in a recession. Austerity measures refer to the measures used by the government to reduce a budget deficit which include spending cuts and tax increases. A reduction in the subsidy on education, which may be implemented as an austerity measure, may reduce the budget deficit. If this happens, the public debt-to-GDP ratio may fall which will help prevent a sovereign default and hence a recession. However, increasing the taxes on demerit goods may be a better measure to reduce a budget deficit both in terms of effectiveness and desirability. Take tobacco for example. As the demand for tobacco is price inelastic due to the high degree of necessity as a result of the addictive nature, an increase in the price due to an increase in the tax is unlikely to induce consumers to reduce the consumption substantially. Therefore, an increase in the tax on tobacco is likely to enable the government to raise a large amount of tax revenue and hence reduce the budget deficit to a larger extent. Furthermore, as the marginal external cost of tobacco consumption increases over time due to rising national income and hence rising demand resulting in rising quantity, an increase in the tax on tobacco will help avoid the problem of under-taxation and hence over-consumption, assuming the tax is initially equal to the marginal external cost.

Evaluation

In the final analysis, the government should not reduce the subsidy on education on the grounds of addressing the problem of income inequity. Although national income has risen over the last few decades, the increase in national income has been concentrated in the hands of high income individuals and this is evidenced by the rising Gini coefficient in most of the economies in the world. For example, the Gini coefficient in Singapore has risen from around 0.41 in 1990 to around 0.48 in 2007. Although it has since declined to around 0.46, it is still substantially higher than the level in 1990. Therefore, the proportionate increase in the incomes of low income individuals is likely to be less than the proportionate increase in the cost of education. It follows that the government should increase the subsidy on education to ensure the affordability to low income individuals. Furthermore, the government should not reduce the subsidy on education on the grounds of addressing the problem of a rising public debt-to-GDP ratio. A reduction in subsidy on education will lead to a rise in the price resulting in a decrease in the quantity demanded and this will have a negative effect on the skills and knowledge of labour in the economy and hence the growth of GDP. In contrast, an increase in the tax on tobacco will lead a rise in the price resulting in a decrease in the quantity demanded and this will lead to a healthier and therefore more productive labour force which will increase the growth of GDP.

The question will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

Click to Read Next Model Essay

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Economics tutors and teachers who wish to use the materials for teaching may submit a request to Economics Cafe.

 

economics tuition, back to homepage

Economics Tuition Singapore @ Economics Cafe
Principal Economics Tutor: Mr. Edmund Quek